Modern Portfolio Theory is much riskier than you have been led to believe.
MPT (standard asset allocation modeling) is largely dependent on normal distribution. Market returns are assumed to cluster in the center of the bell curve while the infrequent big changes dot the outer edges. Dr. Harry Markowitz received a Nobel Prize in Economics for his 1950's ground breaking work creating Modern Portfolio Theory.
If this method of analysis is valid we should be able to accurately forecast how often markets make large moves. Assuming this is valid allows financial advisors using MPT to adjust the risk in your portfolio.
Let’s take a look at how it has worked.
"From 1916 to 2003 there should have been 58 days when the Dow Jones Index Average moved more than 3.4%. Instead it happened on 1,001 days.
There should have been 6 days the Dow swung beyond 4.5%. There were 366.
In 1997 the Dow cratered 7.7% in one trading session. The odds: 1 in 50 billion.
In July of 2002 the Dow declined sharply three times within 7 trading days. The odds: 1 in 4 trillion.
On October 19, 1987 (“the worst day of trading in over 100 years”) the Dow fell 29%. The odds: 1 in 10 to the 50th power – a number outside the scale of nature." *
Modern Portfolio Theory (MPT) does not provide sufficient downside protection for most investors to reach their goals, and, according to Dr. Markowitz, MPT was never intended to provide that protection. He recently explained that his theory never assumed distributions would be "normal," contrary to most financial text books, continuing education and mutual funds sales materials.
Dorsey Wright & Associates published additional research in 2010 using radom sampling of ETFs combined with Monte Carlo processes with similar conclusions. The study concludes that using a universe of global ETFs, more asset classes and relative strength can provide enhanced portfolio results over a market cycle.
Investor expectations for high returns in the aftermath of the tech and real estate bubbles imploding have been dashed against the rocky shore of a transitioning global economy. Several decades of bull market appreciation led to assumptions about our future. The future arrived but the assumptions were overly optimistic. The "buy and hold" strategy has created investor disappointment if not significant losses.
Secular bear markets tend to endure almost as long as bull markets but require a different approach to grow and preserve capital.
We are in a new millenium. It is an increasingly global economy. We are transitioning to a "new normal." It is now time to Buy-DON'T Hold.
We, too, have found that additional risk management is achieved by including a cash proxy as an asset class, such as short-term Treasuries, in the relative strength analysis. The benefit of this process is illustrated in the history section of every 401k plan we have back tested. You can see the results by selecting a plan and clicking on the History Link on any of the plans listed.
"When the facts change, I change my mind. What do you do, sir?" - John Maynard Keynes